October 24, 2014
Welch reigned over General Electric for 20 years between 1981 and 2001. During that time, market capitalization of GE stock
rose from $13 billion to more than $550 billion, sales quadrupled and profits grew six-fold.
Double-digit annual growth
was achieved in good as well as in bad economic times. Consequently, GE stock vastly outperformed the S&P 500, creating
outstanding shareholder value.
In fact over the years, Jack had convinced himself and investors that this was
an entirely predictable and sustainable growth pattern for the company. Much of his legacy was based on that. What possibly
Jack, but certainly investors were missing was that some divisions of GE could only keep up with their numbers after the mid-1990s
by selling their most valuable assets. In a sense, that was the opposite of a fire sale. These assets provided very
generous returns to divisions that were struggling to grow organically.
Implicitly, however, this also demonstrated
some inherent limits to a business model that assumed double-digit growth ad infinitum. Not surprisingly things began
to change in 2001, albeit with bad timing for the then-incoming new CEO of GE, Jeff Immelt.
GE's stock prices had
peaked at around $53 in 2000, but would never again reach such heights. And in fact, while GE stock had outperformed the S&P
500 during Jack Welch's years as CEO, it has largely performed less well than that index under Immelt as the graph below illustrates.
To be sure, this was not Immelt's fault. A number of factors played a very important role. First, the economy was in the
midst of a recession, when Immelt took over. Moreover, Immelt had the bad
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fortune to take the helm of GE just 4 days before the tragic events of 9/11. Among the entire trauma, these events
also caused further harm to the U.S. economy. But the events also led to $600 million in losses for GE's insurance business
and made a serious medium-term dent in the prospects of GE's aircraft business. Of course, the Great Recession was a further
blow to the company.
And yet, this still does not explain why GE did so much worse than the S&P 500 between 2002
and today and why the company's profits rose by only 12% between 2002 and 2013. That double-digit growth occurred over the
entirety of Immelt's leadership, not annually as under Jack Welch.
The main reason, for what shareholders might consider
as underwhelming, is that the tremendous growth of GE during Jack Welch's years created a company with such a humongous asset
base that it simply outgrew a business model that could reasonably assure investors that profits would rise at least 10% a
year. GE has critical mass in the corporate world. Such critical mass does not allow for sustainable double-digit growth any
In that sense, it is not too dissimilar from the world's largest economy, the United States. At a GDP of
$17 trillion it is simply implausible, and in fact it would be highly destabilizing, if the U.S. economy grew at 10% per year.
In year one, such growth would catapult GDP from $17 trillion to $18.7 trillion. As such growth rates would compound over
years, it is beyond global absorptive capacity to sustain such pace.
And this is exactly, where there are parallels
to China's current growth conundrum. Just two years before Jack Welch took over GE, then-de facto leader of China, Deng Xiaoping,
began opening up the Chinese economy in 1979.
The results were astonishing. During the 30 years between 1982 and
2011, the Chinese economy indeed grew by exactly 10% per annum. In 2014, China's GDP will be 35 times larger than it was in
1982. In fact, China now has the second-largest economy in the world at a projected $10.4 trillion. As much of China's
growth was export-driven, its international reserves grew by leaps and bound from a measly $7 billion in 1982 to a project
$4.2 trillion in 2014.
China's economy now has critical mass. For decades, it was the mantra of Chinese leadership
that economic growth below 8% was unacceptable and even socially unsustainable. This is no longer so. In 2012 and 2013,
GDP grew by "only" 7.7% each and growth in 2014 is expected to be even slower.
The reason is simple.
Much like in the case of GE, China's "asset base", its GDP, has grown so large that double-digit growth is no longer
sustainable. In the case of GE, the first warning signals were that some divisions had to sell valuable assets to make
their numbers. In the case of China, the signals are that the current supply of low-cost consumer products provided by China
exceeds demand in the more advanced countries. This is partly so because China's supply has multiplied, flooding global markets.
Partly it is the result of demographic changes and a prolonged economic crisis in the more advanced countries, which has dampened
Of course, all of this has led to advice from outside of China that it change its business model from one
driven by investments to one driven by consumption. After all, China has a very large population and, in terms of per capita
income, it is still a fairly poor country. And yet, gross domestic savings stand at over 50% of GDP. So, there is a lot of
growth potential in the domestic Chinese economy.
Still, a shift from the export-driven to a consumption-driven growth
model is easier said than done because as a society China is not as open as its economy. Moreover, China itself is facing
one of the greatest demographic challenges of humankind. By 2050, one-fourth of all Chinese will be older than 65. In
fact, as has been said many times before, China will be old before it will be rich.
Moreover and in spite of high
domestic savings, there are major economic imbalances in China. In order to maintain high growth rates during this difficult
transition period, credit growth has been out of control for years. Between 2009 and 2013 domestic credit has grown at an
annual average of 19.7%. It does not take an economist to figure that returns were probably negative for a lot of that lending,
since GDP only grew at an annual rate of 8.9% during that time period.
China's banking system is now two-and-a-half
times the size of its GDP and it is twice as large as the U.S. system. Meanwhile, the balance sheets of financial institutions
are badly impaired; although it is everybody's guess how badly. State-owned corporations as well as the country's provinces
and municipalities are deeply indebted. The seriousness of this problem is illustrated by the fact that a Chinese audit in
late 2013 determined that local governments alone had some $3 trillion in debt. In looking at these challenges, China's enormous
international reserves are quickly put in perspective.
Size matters. And China is now
an economy that needs a comprehensive makeover and one that requires transparency. This is easy undertaking. China's medium-term
growth potential may not be much greater than 5% per annum. However, reaching that potential requires dealing with existing
imbalances and managing social implications of such relative decline. One thing is for certain, China's "stock"
much like GE's will fall and it will find a new equilibrium.Enter content here